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The Taylor rule is an economic concept that suggests how the United States Federal Reserve or any central bank should set short-term interest rates. Proposed by a Stanford University economist, the rule is meant as a guideline for balancing complicated nationwide economic factors. Many experts suggest that the general adherence of the US Federal Reserve to the Taylor rule has kept inflation under control throughout the United States.
The interest rate is a fee charged on borrowed money or assets. Lenders make most of their money through the interest charged on loans. In the United States, the Federal Reserve sets the interest rate at which banks can charge each other for interbank loans. Setting the reserve rate can stabilize the amount of money in the economy, and help maintain inflation levels. The Taylor rule is often followed as a rule of thumb for how the interest rate should be adjusted.
Two concerns factor into setting interest rates: employment levels and inflation. Inflation is the devaluation of money’s buying power and can be caused by many issues in the economy. One of the most common reasons for inflation is that there is too much money in an economy, causing each dollar to be worth less and making prices go up. Employment levels are seen as a measure of the health of the economy, and can affect the buying ability of consumers. High employment means a better ability to buy, while lower employment means that consumers have less free resources to get loans or make investments.
There are three main factors on which the Taylor rule operates. The first question is where the inflation rate is compared to where the central bank wants it. If the inflation rate is higher than the targeted rate, interest rates should be increased to lower inflation. This reduces the amount of money in the economy, which means that the buying value of each dollar will go up.
The second principle of the Taylor rule regards the state of employment in the affected area. If employment is at or above full levels, the interest rate should be increased since employed people are better able to afford loans. When employment is considerably lower than full levels, the rule suggests decreasing interest rates in order to lower prices to help people with less than usual income.
The third factor is actually a combination of the first two principles. According to the rule, the correct short-term interest rate will be able to maintain an economy at full employment while remaining at targeted inflation rates. The third principle of the Taylor rule tries to ensure a balance between conflicting situations such as “stagflation,” when inflation is high despite high employment levels. Ideally, the rule suggests, a healthy economy should be able to bring both employment and inflation into balance.
While the US Federal Reserve has not explicitly followed the guidelines, it has been widely accepted as a good way of determining economic policy. Under the Fed Chairman Alan Greenspan, United States policy followed the rules in a general way. Many believe adherence to Taylor’s rules has helped the US pull out of the enormous inflation crisis of the 1970s and maintain mostly healthy levels of growth since the 1990s.